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HE9091

Principles of Economics
Lecture 1
Introduction to Economics
Tan Khay Boon
Email: khayboon@ntu.edu.sg

Topics

Scarcity and Cost-Benefit Principles


Opportunity Cost and Incentive Principle
Demand and Supply
Market Equilibrium and Price Control
Shifts in Demand and Supply
Efficiency and Equilibrium Principles
Reference: FBLC, chapters 1, 3 & 6

The Scarcity Principle

The Cost-Benefit Principle


Take an action if and only if the extra benefits
are at least as great as the extra costs
Costs and benefits are not just money

Applying the Cost Benefit


Principle
Assume people are rational
A rational person has well defined goals and tries to
fulfill those goals as best they can

Would you walk to town to save $10 on an


item?
Benefits are clear
Costs are harder to define

Hypothetical auction
Would you walk to town if someone paid you $9?
If you would walk to town for less than $10, you gain
from buying the item in town

Cost Benefit Principle


Examples

Economic Surplus
The economic surplus of an action is equal
to its benefit minus its costs

Opportunity Cost
Opportunity cost is the value of what must
be foregone in order to undertake an activity
Consider explicit and implicit costs

Examples:
Give up an hour of babysitting to go to the
movies
Give up watching TV to walk to town

Caution: NOT the combined value of all


possible activities
Opportunity cost considers only your best
alternative

Sunk Cost
Sunk Costs are costs that are beyond
recovery when a decision is made
Irrelevant to future decision making
Only costs that influence a decision are
those that can be avoided by not taking
the decision
Only benefits that influence a decision are
those that would not occur unless the
action were taken.

Buyers and Sellers


Cost-Benefit Principle is behind decision making
Buyers: buy one more unit?
Only if marginal benefit is at least as great as
marginal cost

Sellers: sell one more unit?


Only if marginal benefit (marginal revenue) is at
least as great as marginal cost

Opportunity Cost also matters


Buyers: hamburger or pizza?
Sellers: recycle aluminum or wash dishes?

The Importance of Opportunity


Cost
Harry can divide his time between two
activities:
Wash dishes for $6 per hour
Recycle aluminum cans and earn 2 per can

Harry only cares about the income


How much labor should Harry supply to each
activity?
Harry should devote an additional hour to
recycling as long as he is earning at least $6 per
hour

Economic Models
Simplifying assumptions
Which aspects of the decision are absolutely
essential?
Which aspects are irrelevant?

Abstract representation of key relationships


The Cost-Benefit Principle is a model
If costs of an action increase, the action is less
likely
If benefits of an action increase, the action is
more likely

Marginal Analysis Ideas


Marginal cost is the increase in total cost
from one additional unit of an activity
Average cost is total cost divided by the number
of units

Marginal benefit is the increase in total


benefit from one additional unit of an activity
Average benefit is total benefit divided by the
number of units

Marginal Analysis: NASA


Space Shuttle
# of Launches

Total Cost
($B)

Average Cost
($B/launch)

$0

$0

$3

$3

$3

$7

$3.5

$4

$12

$4

$5

$20

$5

$8

$32

$6.4

$12

Marginal Cost
($B)

If the marginal benefit is $6 billion per launch, how many launches


should NASA make?

Normative and Positive


Economics
Normative economic
principle says how
people should behave
Gas prices are too
high
Building a space base
on the moon will cost
too much

Positive economic
principle predicts how
people will behave
The average price of
gasoline in May 2010
was higher than in
May 2009
Building a space base
on the moon will cost
more than the shuttle
program

Incentive Principle

Microeconomics and
Macroeconomics
Microeconomics studies
choice and its implications
for price and quantity in
individual markets
Sugar
Carpets
House cleaning services
Microeconomics considers
topics such as
Costs of production
Demand for a product
Exchange rates

Macroeconomics studies
the performance of national
economies and the policies
that governments use to try
to improve that performance
Inflation
Unemployment
Growth
Macroeconomics considers
Monetary policy
Deficits
Tax policy

Simultaneous Equations
Two equations, two unknowns
Solving the equations gives the values of the
variables where the two equations intersect
Value of the independent and dependent variables
are the same in each equation

Example
Two billing plans for phone service
How many Mbytes make the two plans cost the
same?

Simultaneous Equations
Plan 1
Plan 2

B = 10 + 0.04 D
B = 20 + 0.02 D

Plan 1 has higher per minute price while Plan 2 has


a higher monthly
fee

Find B and D
for point A

Simultaneous Equations
Plan 1 B = 10 + 0.04 D
Plan 2 B = 20 + 0.02 D
Subtract Plan 2 equation from
Plan 1 and solve for D

Find B when D = 500


B = 10 + 0.04 D
B = 10 + 0.04 (500)
B = $30

B = 10 + 0.04 D
B = 20 0.02 D
0 = 10 + 0.02 D

OR

D = 500

B = 20 + 0.02 D
B = 20 + 0.02 (500)
B = $30

What, How, and For Whom?


Every society answers three basic questions
WHAT

Which goods will be produced?


How much of each?

HOW

Which technology?
Which resources are used?

How are outputs distributed?


FOR
Need?
WHOM
Income?

Central Planning versus the


Market
Central Planning
Decisions by
individuals or small
groups
Agrarian societies
Government programs
Sets prices and goals for the
group
Individual influence is
limited

The Market
Buyers and sellers
signal wants and costs
Resources and goods are
allocated accordingly
Interaction of supply and
demand answer the three
basic questions

Mixed economies use both the market and central planning

Buyers and Sellers in the


Market
The market for any good consists of all the
buyers and sellers of the good
Buyers and sellers have different motivations
Buyers want to benefit from the good
Sellers want to make a profit

Market price balances two forces


Value buyers derive from the good
Cost to produce one more unit of the good

Demand
A demand curve
illustrates the quantity
buyers would purchase
at each possible price
Demand curves have a
negative slope
Consumers buy less at
higher prices
Consumers buy more
at lower prices

Demand for Donuts


P
$4
$2

16

(000s of pieces/day)

Law of Demand
Law of Demand
Consumers buy less of a product
as the price of the product rises
Price and quantity demanded are inversely related

Law of Demand
Cost-Benefit Principle at work
Do something if the marginal benefits are at least
as great as the marginal costs

An increase in the market price approaches our


reservation price
If market price (cost) exceeds the reservation price
(benefit), buy no more

Demand Slopes Downward


Buyers value goods differently
The buyers reservation price is the highest price
an individual is willing to pay for a good

Demand reflects the entire market, not one


consumer
Lower prices bring more buyers into the market
Lower prices cause existing buyers to buy more

Income and Substitution Effects


Buyers buy more at lower prices and buy less at
higher prices
What happens when price goes up?
The substitution effect: Buyers switch to
substitutes when price goes up
The income effect: Buyers' overall purchasing
power goes down

Interpreting the Demand Curve


Demand for Donuts
P
$4
$2

16

(000s of pieces/day)

Horizontal
interpretation of
demand:
Given price, how much
will buyers buy?
At a price of $4, the
quantity demanded is
8,000 slices/day.

Interpreting the Demand Curve


Demand for Donuts
P
$4
$2

16

(000s of pieces/day)

Vertical interpretation of
demand:
Given the quantity to
be sold, what price is
the marginal consumer
willing to pay?
If 8,000 slices are sold
the marginal consumer
is willing to pay $4 per
slice.

The Supply Curve


The supply curve illustrates the quantity of a
good that sellers are willing to offer at each price
Producers incur costs in order to obtain resources
to produce output and sell to consumers at the
market price to maximize profits
The Low-Hanging Fruit Principle explains the
upward sloping supply curve
The sellers reservation price is the lowest price
the seller would be willing to sell for
Equal to marginal cost of production

Law of Supply
Law of Supply
Producers supply more of a product
as the price of the product rises
Price and quantity supplied are positively related

Interpreting the Supply Curve


Supply of Donuts
P
S

$4
$2
8

16

(000s of pieces/day)

Horizontal
interpretation of
supply:
Given price, how much
will suppliers offer?
At a price of $2,
suppliers are willing to
sell 8,000 pieces/day.

Interpreting the Supply Curve


Supply of Donuts
P
S

$4
$2
8

16

(000s of pieces/day)

Vertical interpretation of
supply:
Given the quantity to
be sold, what is the
opportunity cost of the
marginal seller?
If 8,000 pieces are
sold, the marginal cost
of producing the
8,000th piece is $2.

Market Equilibrium
A system is in equilibrium when there is no
tendency for it to change
The equilibrium price is the price at which the
supply and demand curves intersect
The equilibrium quantity is the quantity at
which the supply and demand curves intersect
The market equilibrium occurs when all buyers
and sellers are satisfied with their respective
quantities at the market price
At the equilibrium price, quantity supplied equals
quantity demanded

Market Equilibrium
Quantity supplied
equals quantity
demanded AND
Price is on supply
and demand curves
No tendency to
change P or Q
Buyers are on their
demand curve
Sellers are on their
supply curve

Market for Donuts


P
S

$3
D

Q
12
(000s of pieces/day)

Excess Supply and Excess


Demand
Excess Supply

Excess Demand

At $4, 16,000 pieces supplied


and 8,000 slices demanded

At $2, 8,000 pieces supplied


16,000 slices demanded

Market for Donuts


P

Market for Donuts


P
Surplus S

$4
D

16

(000s of pieces/day)

$2
Q

Shortage
D

Q
16
8
(000s of pieces/day)

Incentive Principle: Excess


Supply at $4
Each supplier has an
incentive to decrease the
price in order to sell more
Lower prices decrease the
surplus
As price decreases:
the quantity offered for sale
decreases along the supply
curve
the quantity demanded
increases along the
demand curve

Market for Donuts


P
$4
$3.50
$3

Equilibrium
D
8 12 16
(000s of pieces/day)

Incentive Principle: Excess


Demand at $2
Market for Donuts
P

$3
$2.50
$2

Equilibrium
D
8 12 16
(000s of pieces/day)

Each supplier has an


incentive to increase the
price in order to sell more
Higher prices decrease the
shortage
As price increases
the quantity offered for
sale increases along the
supply curve
As price increases, the
quantity demanded
decreases along the
demand curve.

Rent Controls Are Price Ceilings


A price ceiling is a
maximum allowable price,
Market for New York City Apartments
set by law
P
Rent controls set a maximum
S
price that can be charged for
a given apartment
If the controlled price is
$1,600
below equilibrium, then:
$800
Quantity demanded
D
increases
Q
1 2 3
Quantity supplied
(millions of apartments/day)
decreases
A shortage results

Movement along the Demand


Curve
When price goes up,
quantity demanded
goes down
When price goes
down, buyers move to
a new, higher quantity
demanded
A change in quantity
demanded results
from a change in the
price of a good.

Demand for Canned Tuna

$2
$1

8 10

(000s of cans/day)

Shift in Demand
If buyers are willing to
buy more at each price,
then demand has
increased
Move the entire demand
curve to the right
Change in demand

If buyers are willing to


buy less at each price,
then demand has
decreased

Demand for Canned Tuna

P
$2
D

8 10

(000s of cans/day)

D'

Causes of Shifts in Demand


Price of complementary goods
Tennis courts and tennis balls

Price of substitute goods


Internet and overnight delivery are substitutes

Income: normal or inferior goods?


Preferences
Dinosaur toys after Jurassic Park movie

Number of buyers in the market


Expectations about the future
Price changes never cause a shift in demand

Tennis Market
If rent for tennis court decreases, demand for tennis
balls increases
Tennis courts and tennis balls are complements

Tennis Court Rentals


P

Tennis
Ball
Sales
P
S

$10

$1.40
$1.00

$7

D'

D
4

11

(00s rentals/day)

D
40

58

(millions of balls/day)

Demand for Apartments


If income rise, demand for
apartments increases

Apartments

Demand increases

D'

Price increases
Quantity increases

Demand for a normal


good increases when
income increases

P'
P
Q Q'
(units/month)

Demand for an inferior good


increases when income
decreases

Movement Along the Supply


Curve
When price goes up,
quantity supplied
goes up
When price goes up,
sellers move to a
new, higher quantity
supplied
A change in quantity
supplied results from
a change in the price
of a good.

Supply
of Donuts
P
S

$4
$2
8

16

(000s of pieces/day)

Shift in Supply
Supply increases when
sellers are willing to offer
more for sale at each
possible price

Supply decreases when


sellers are willing to offer
less for sale at each
possible price

Moves the entire supply


curve to the right

Moves the entire supply


curve to the left

Supply of
P Donuts S

S'

Supply of
P Tuna
S*

$2

$2
8 9
(000s of pieces/day)

8 9
(000s of cans/day)

Causes of Shifts in Supply


A change in the price of an input
Steel for bicycles, skill workers wages

A change in technology
Desktop publishing and term papers
Internet distribution of products (e-commerce)

Weather (agricultural commodities and outdoor


entertainment)
Number of sellers in the market
Expectation of future price changes
Price changes never cause a shift in supply

Shifts in Supply: Bicycles


Costs of production affect the supply of a
product
Cost of steel for bicycles increases
Supply decreases
With no change in demand,
the price of bicycles
increases to $80 and quantity
decreases to 800

Supply of Bicycles

S'

$80
$60

S
D

600 800 1,000


(bicycles/month)

Shift in Supply: Handmade


Carpets
Cost of labor used to produce handmade
carpets decreases
Supply increases

Demand is constant
The price of handmade
carpets decreases to
$90,000 per carpet
Quantity increases to 50

The Market for Handmade Carpets

$120
$90

S'
D

40 50

(carpets/
month)

Supply and Demand Shifts:


Four Rules
An increase in demand will lead to an increase in
both equilibrium price and quantity
P
S

P'
P

Q'

D'
Q

Supply and Demand Shifts:


Four Rules
An decrease in demand will lead to a decrease
in both equilibrium price and quantity
P
S

P
P'

Q'

D'

Supply and Demand Shifts:


Four Rules
An increase in supply will lead to a decrease in the
equilibrium price and an increase in the equilibrium
quantity.
P

S
S'

P
P'

D
Q

Q'

Supply and Demand Shifts:


Four Rules
An decrease in supply will lead to an increase in
the equilibrium price and a decrease in the
equilibrium quantity.
S'

P'
P
D

Q'

Supply and Demand Both


Change: Tortilla Chips
Oils used for frying are harmful AND the price of
harvesting equipment decreases

Price ($/bag)

S'

P'
D
D'

Q' Q

Millions of bags per month

Changes in Supply and Demand


Supply
Demand

Increases

Decreases

Increases

P Depends
Q Increases

P Increases
Q Depends

Decreases

P Decreases
Q Depends

P Depends
Q Decreases

Efficiency and Equilibrium


Markets communicate information effectively
Value buyers place on the product
Opportunity cost of producing the product

Markets maximize the difference between


benefits and costs
Market outcomes are the best provided that
The market is in equilibrium AND
No costs or benefits are shared with the public

Cash on the Table


Buyer's surplus: buyer's reservation price
minus the market price
Seller's surplus: market price minus the seller's
reservation price
Total surplus = buyer's surplus + seller's
surplus
Total surplus is buyer's reservation price seller's
reservation price

No cash on the table when surplus is


maximized
No opportunity to gain from additional sales or
purchases

Efficiency Principle
The socially optimal quantity maximizes total
surplus for the economy from producing and
selling a good
Economic efficiency -- all goods are produced at
their socially optimal level

Efficiency Principle: equilibrium price and


quantity are efficient if:
Sellers pay all the costs of production
Buyers receive all the benefits of their purchase

Efficiency: marginal cost equals marginal


benefit
Production is efficient if total surplus is maximized

Equilibrium Principle
Equilibrium Principle: a market in equilibrium
leaves no unexploited opportunities for
individuals
Only when the seller pays the full cost of
production and the buyer captures the full
benefit of the good is the market outcome
socially optimal

From Graphs to Equations


Sample equations
P = 16 2 Qd
is a straight-line demand curve with intercept 16
on the vertical (P) axis and a slope of 2
P = 4 + 4 Qs
is a straight-line supply curve with intercept 4
and a slope of 4

To Equilibrium P and Q
Equilibrium is where P and Q are the same for
demand and supply
Set the two equations equal to each other (P = P)
and solve for Q (Qs = Qd = Q*)
16 2 Q* = 4 + 4 Q*
6 Q* = 12
Q* = 2

Use either the supply or demand curve and Q * =


2 to find price
P = 16 2 Q*
P = $12

P = 4 + 4 Q*
P = $12